February 2013

The legacy of the global financial crisis has seen a raft of new legislation arriving alongside new market requirements for capital rules, liquidity and collateral eligibility.

As a result, broker-dealers, financial institutions and institutional investors around the world will find themselves operating day-to-day in a far more complex business and regulatory environment.

Crucially, institutional investors have to take a long, hard look at how better to utilise and manage their collateral. Buy-side firms will have a greater need to post initial and variable margin in the shape of high-quality collateral. At the same time, they will be expected to hold higher levels of exchange-eligible collateral on their balance sheets.

That means that both sell and buy-side firms will be under pressure to optimise their collateral.

The collateralisation of exposures may for many be a new fact of life, but it is here to stay, and not just because regulators mandate it – the markets demand it. So how to address this impending collateral challenge?

Any institution that needs to post collateral needs to “optimise” its assets. There are questions an institution should ask itself, and be able to answer. For instance, is there a workflow in place that can categorise its collateral demands, send or receive collateral from its counterparties and process this information with other firm-wide systems? Is there appropriate connectivity and reporting in place in respect of collateral? And, finally, does it possess the ability to execute a complex plan to analyse this data and determine the optimal way to get the most out of assets on hand, taking into account complicating factors such as cost or the requirements of the central counterparty (CCP) on the other side?

The next potential step involves collateral “transformation”. CCPs are strict about what type of collateral they will accept: it has to be liquid, high-quality and easily valued. But once you go beyond high-quality sovereign and agency paper, European-covered bonds and, to a limited degree, top-tier corporate bonds, there is not much more that meets the necessary criteria.

So where does that leave an institution that needs to post collateral, but does not own eligible assets? The answer is to swap assets that CCPs or other counterparties will not take for those assets that will be accepted – and so “transform” the collateral they hold. For asset owners, including pension plans, there exists a clear revenue opportunity here.

Collateral transformation is not always straightforward. Capital and balance sheet constraints will come into play, while investment-related risks are shifted, not eliminated. One of the biggest challenges around collateral transformation is determining, among other things, who needs the assets, who holds them, who assumes which risks and what are the pricing parameters. All these considerations need to be factored in. The expertise required exists primarily in repo and securities lending desks.

Beyond optimisation and transformation, clients are also looking to their providers to segregate assets, specifically utilising tri-party structures, to protect their assets and retain the ability to move them as necessary. Investors prefer their collateral to be isolated from other clients’ assets and easily tracked, transparently priced, and transferable.

Tri-party arrangements, where collateral is held by a custodian who manages the operations on behalf of the party pledging the paper as well as those benefiting from the pledge, have been around for some time.

These relationships are now expanding to include CCPs and other institutions worldwide. Subject to a pre-agreed eligibility schedule, tri-party custody providers can effect collateral substitutions and other transfers, as well as mark collateral to market, deliver transparent reporting and manage connectivity between all the parties.

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